MSFT - Microsoft: Firing On Most Cylinders

2023-05-01 04:14:42 ET

Summary

• Microsoft's shares have rebounded from their 2022 lows.
• The company has seen resilient sales growth in an uncertain macro environment.
• ChatGPT and AI have bolstered the imagination of the shares, as investors appear to be betting that it could broaden and accelerate Microsoft's growth.
• Despite huge uncertainty on the Activision deal, the company sees solid growth, as investors might have gotten a bit too excited to price its prospects again.

Shares of Microsoft ( MSFT ) have come to life again, surpassing the $300 mark, on the back of a widespread rally of share prices in technology names and operational momentum, despite uncertainty on the pending and prolific $70 billion Activision Blizzard ( ATVI ) deal.

In September, I concluded that we were seeing a re-rating after strong performance in the years before.

A Recap

After posting solid results in the pandemic year 2020, Microsoft stepped up its performance in 2021, reporting a solid 18% increase in full year sales to $168 billion. The company is extremely profitable, posting operating profits around $70 billion and adjusted net earnings of $60 billion, being close to $8 per share.

With momentum being strong at the start of 2022, the firm was on track to generate $200 billion in sales in 2022, with earnings likely coming in closer to $9 per share, as net cash of $77 billion worked down to a net cash position of around $10 per share based on a 7.5 billion share count.

Shares peaked around the $350 mark late in 2021 and traded in the low $300s in spring of 2020, translating into a demanding valuation at 33 times forward earnings. Trading in the low $300s, Microsoft was valued at $2.3 trillion early in 2022 as the $70 billion deal for Activision is staggering in dollar terms, yet was equal to just 3% of the valuation of Microsoft, as the move was designed to add a few high profile gaming titles like Call of Duty and World of Warcraft to its line-up.

Through 2022 shares fell to $240 in September, when I last looked at Microsoft and its prospects. The share pullback came amidst rising interest rates, which made the earnings yield offered by Microsoft less compelling, while continued uncertainty on the Activision deal and strong dollar hurt prospects as well. The company posted a solid 20% increase in second quarter sales, 18% increase in third quarter sales, yet fourth quarter sales growth slowed down to 12%. This slower growth was to an important extent the result of the stronger dollar, subtracting four points from revenue growth, but macro trends were softening as well.

In the end, the company posted full year sales of $198 billion and earnings of $9.21 per share, in line with my expectations, as net cash fell to $55 billion following the Nuance deal closing. This made that at $241 per share, valuation multiples had fallen from 30 to 33 times earnings to 25 times earnings, pushing up the earnings yield by nearly a point to 4%.

This was a lot more compelling, yet the earnings yield was more or less in line with risk-free rates, as the company was clearly seeing some kind of growth slowdown as well. While the company - under the leadership of Mr. Nadella - has seen a remarkable performance, I have not forgotten about the years or decades in the 2000s when shares traded at very non-demanding valuation multiples.

I ended up concluding that I was looking to add around the $200 mark, but shares only saw lows of $213 per share in November, as I unfortunately did not manage to buy into a position. Ever since shares have risen nearly 50%, especially in recent weeks, amidst a momentum run higher.

Very Strong Momentum

Since my upbeat but too cautious stance in September, Microsoft has been doing alright. First quarter sales for the fiscal year 2023 rose 11%, this time held back by a five point headwind from the dollar. Second quarter sales rose just 2%, again including a five point headwind from the dollar. The third quarter results, as released in April, gave reason to become upbeat again. Reported sales were up 7%, as the dollar now only created a 3% headwind to growth after recently losing some of its strength.

Quarterly revenues rose to $52.9 billion in dollar terms as operating profits rose even quicker than topline sales growth with operating profits of $22.4 billion translating into handsome margins. Net earnings rose to $18.3 billion, resulting in a 10% increase in earnings to $2.45 per share.

At this rate a near $10 earnings per share run rate is in sight, very promising. Net cash is quite stable at $56 billion, equal to just over $7 per share. Growth is driven by double digit sales growth in cloud, office, Dynamics, LinkedIn, Azure and search, thereby being quite diversified.

Investors like this increased momentum, as Microsoft seems to be a leader in AI, a key feature these days of course, as it could change the outcome and hierarchy between the big tech names. Given its small reliance on search engine Bing, a solution like ChatGPT and related AI solutions could give Microsoft a greater portion of the search market, and perhaps render search as we know it today useless in the future.

Not a single word was mentioned on the pending Activision deal, which the UK Competition and Markets Authority essentially killed over the last week by blocking the merger, citing concerns on the market for cloud gaming, a market still in development of course. While it is too early to conclude that the deal has been killed, it has suffered a major blow at best, including a large delay, as the likely impact is that chances of the deal have slimmed down significantly.

Concluding Thoughts

While the Activision deal is high-profile, it does not alter the near term investment case for Microsoft here in my view. The reality is that Microsoft is earning $10 per share right now and while double digit growth looks decent in an uncertain macro-environment, the reality is that multiples have expanded from 25 times earnings to 30 times earnings again, all in a high interest rate environment.

I believe that a big part of this is due to the exposure to AI and ChatGPT in particular, which holds real promises; yet at the same time it does not add any meaningful number in the near term, but investors appear to be pricing in these prospects.

These technologies have the promise to bolster the growth positioning of the firm even more in stone. The question is if reliable 10% growth here justifies 30 times multiple, given the interest rate environment. Hence, I feel no need to chase the shares here, and while I have just missed my entry point last autumn, I am willing to commit at a low twenty-times multiple, let's say $225 per share based on the current performance.

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